Exchange Rate a Drag on Australian Market Performance

In failing to match moves in the Dow Jones and S&P 500, Australia's stock market appears to have lagged behind the results from a far less buoyant economy. Taking account of the interaction of profits and exchange rates in a global market can change that perspective.

At the close of North American markets on Friday, the S&P 500 registered 1,551.18 as it came within 1% of the highest closing price since October 2007 (1,565.15). But the 2007 peak preceding the stock market crash accompanying the global financial crisis was little different from the value of 1,527 reached in March 2000.

In short, while the value of the S&P 500 is on the edge of a new record, there has been little net gain over more than a dozen years.

The most recent close for the Australian All Ordinaries benchmark was 25% below its October 2007 high point. This seemingly disappointing result came while Australia's economy was benefiting from a systemically stronger financial system as well as its proximity to Asia and China's appetite for raw materials and while the US economy has often struggled to avoid recession.

The comparison implies a shortcoming in the Australian performance and, depending on the person making the comparison, an optimistic hint of Australian markets having scope to make up lost ground.

Since March 2009, the S&P 500 has risen at an annualised rate of 16.8% backed by a record 130% recovery in corporate earnings. By the end of 2012, the S&P 500 earnings recovery had been sufficiently strong to return them to the level they had reached in mid 2007.

Given the path of US earnings in the past five years, the market movement is not especially surprising. There was a basis for significant upward momentum for much of this time.

The earnings momentum which helped drive the market has weakened considerably in more recent months putting a valuation constraint on the upward movement of the index. The S&P 500 index is trading at a multiple of 15.3 times annualised December quarter earnings. In 2007, the multiple at the point of peak earnings had been 15.6.

The pattern of S&P 500 earnings has been broadly similar to economy wide profitability measures. U.S. after tax corporate profits peaked in the 2006 September quarter, then declined by 53% and, from that low base in the December quarter of 2008, increased by 170% by the September quarter of 2012 (the last quarter for which these statistics are available).

There are two main differences between the two US profit series. The macro profit measure published by the government began turning down three quarters before the downturn in the S&P earnings became evident. Secondly, the macro measure was already 27% ahead of its prior peak value last September.

The Australian market had recorded its low point in March 2009 after which the All Ordinaries share price index has risen 66%. Over this same period, Australian corporate private gross operating surplus, the macro profit measure published in Australia's national accounts, declined at an annual rate of 0.1%, despite the much touted buoyancy of Australian economic conditions.

Comparisons over time can be misleading insofar as conclusions will depend on the choice of beginning and end points. Australia's corporate operating surplus increased at a rate of 7.9% between 2000 and the end of 2012, for example. Over this time, S&P 500 earnings increased by just 4.2% a year. And, again over the same period of time, the Australian market rose by 3.2% a year while the S&P 500 was slightly negative (-0.2% pa).

Looked at this way, the Australian market has been doing solidly better.

Another perspective on the apparently poor recent relative performance of the Australian market takes account of how much international investors have been prepared to pay for local profits. This perspective recognises the important role of overseas institutions in pricing Australian equities based on global valuation comparisons.

Since early 2009, the US dollar value of Australian corporate profits has risen at an annualised rate of 10.5% and the market here, again measured in US dollars, has increased at a 15.3% rate (compared with the 12% S&P 500 rate of increase).

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